Corporate Profit Margins Are Finally Stabilizing, Creating New Tailwind for Stocks

Companies across industries are still battling higher prices for labour, materials and energy

A positive trend is emerging at large US companies, as a greater portion of their revenue is contributing to their net profit. This development may serve as an encouraging sign for a stock market that has been stagnant in recent weeks.

As we approach the midpoint of the first-quarter earnings season, it appears that the net profit margin of companies within the S&P 500 has increased slightly to 11.5%, up from 11.3% in the previous quarter. These figures are based on both actual results and projections for companies that have yet to report.

This marks the first upswing in six consecutive quarters of declining margins, leading John Butters, senior earnings analyst at FactSet, to suggest that margins may have reached their lowest point. Net profit margins reached a peak of 13% in the second quarter of 2021 before beginning their descent.

S&P 500 Companies’ Net Profit Margin

It is currently uncertain whether the recent cost pressures will persist over the long term and result in increased corporate profits. Various industries continue to face challenges such as higher prices for essential inputs like labour, materials, and energy, as well as increasing borrowing costs due to the Federal Reserve’s aggressive interest rate hikes.

However, the improvement in margins offers some consolation to investors who are attempting to assess the economy’s trajectory amid the ongoing interest rate hikes. While the S&P 500 has risen by 6.5% in 2023, it has remained relatively stable over the past month.

Despite this positive development, Lisa Erickson, the head of the public markets group at U.S. Bank Wealth Management., advises clients to remain somewhat defensive given the ongoing inflationary pressures and uncertainties surrounding consumers’ ability to maintain their resilient spending patterns.

In light of the uncertain economic environment, Lisa Erickson recommends that investors hold fixed-income assets and stocks in the real estate and infrastructure industries for their reliable dividend payments.

Historically, corporate earnings have been a significant driver of stock gains, and the latest earnings season has generally been better than expected. With results available from nearly 70% of the companies in the S&P 500, profits are estimated to have declined by 2.9%. This marks a considerable improvement from the projected 6.7% decline at the end of the quarter, demonstrating a more favourable outlook.

However, many companies are still striving to cut costs due to elevated inflation levels and increasing wage gains in the first quarter. For instance, 3M recently announced its decision to streamline its corporate operations, simplify its supply chain, and reduce management layers by cutting 6,000 jobs in addition to the 2,500 positions announced in January. The company reported a 25% decrease in earnings while facing weak demand for its products, causing its shares to drop by 14% this year.

Similarly, Tyson Foods is under pressure to reduce its costs and has announced plans to eliminate 15% of its senior leadership positions and 10% of its corporate roles. The company, the largest US meat supplier by sales, has seen its stock decline by 2.7% this year.

On Wednesday, the Federal Reserve raised interest rates by another quarter-percentage point, setting the range between 5% and 5.25%, a 16-year high, while also indicating that it could potentially stop lifting rates after this increase. The Fed has raised interest rates 10 times consecutively in an effort to combat inflation, but the effects have been slow to trickle through the economy.

United States Fed Funds Rate

While wage growth and steady hiring threaten to maintain inflation levels, consumer spending and factory activity have slowed down, and stress in the banking sector has made investors anxious about a possible recession.

A recession can have negative effects on both the stock market and corporate earnings. Research from Deutsche Bank shows that the S&P 500 has typically declined 24% in recessions dating back to 1946. Additionally, D.A. Davidson notes that during the past ten recessions going back to 1957, earnings among companies in the S&P 500 fell 30% on average. If the more pronounced downturns that occurred during the dot-com bubble burst and the 2008-2009 financial crisis are excluded, profits decreased by 19%.

S&P 500 Earnings – 90-Year Historical Chart: Click on the link to use the interactive chart.

While this time may be different, it might not be enough to break stocks out of their lull. Economists generally expect any recession in 2023 to be relatively quick and shallow. However, analysts predict that profits will fall again this quarter before starting to climb in the second half of the year. For the calendar year, earnings are expected to increase by just 1.2%.

Stocks still appear expensive from a historical perspective. The S&P 500 is currently trading at approximately 18 times its projected earnings over the next 12 months, which is higher than the 10-year average of 17.3, according to FactSet.

Investor sentiment remains bearish, which is typically a contrarian indicator for the market. The most recent survey from the American Association of Individual Investors found that 38.5% of investors are bearish about the stock market’s direction, above historical levels but improved from March.

Dylan Kremer, a co-chief investment officer of Certuity, a multifamily office that manages over $4 billion in assets, said, “I think there’s some room for disappointment later in the year, but the bearish sentiment and high cash on the sidelines are two major factors and a ballast to equities.”

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